By Robert Pozen and Theresa Hamacher,

Government workers’ pensions may sound like an obscure topic, but it’s front and center in some of the most rancorous of today’s political discussions. Retirement benefits for public workers are at the heart of the conflict between state and local governments and the unions representing their workers — and how that conflict gets resolved will affect investors in the municipal bonds issued by those states and cities. Let’s take a look at the looming public pension crisis, its effect on municipal finance and how accounting reform might help.

As most corporations have shifted sharply away from traditional pension plans toward 401(k)s, the public sector has not followed suit. At the end of 2008, almost 80 percent of state and local government employees remained covered by a traditional pension plan, compared with only one-third of those employed by medium- and large-size businesses.

In a traditional pension plan, the employer guarantees that workers will receive retirement benefits according to a defined schedule based on salary levels and years worked. If contributions to the plan and its investment returns are insufficient to pay these benefits, the employer — in this case, the governmental unit — must make up the shortfall.

Unfortunately, most public pension plans are poorly funded. The Pew Center on the States calculates that the 50 states collectively face a $600 billion pension shortfall. But the shortfall is much worse than that. First, Pew’s estimate doesn’t include the shortfalls from government pensions at the city and county levels. Second, and most critically, estimates such as Pew’s rely on the existing, deficient rules for pension accounting.

This growing shortfall will threaten the fiscal health of state and local governments, putting long-term pressure on their municipal bonds. So if you want to take advantage of municipal bonds’ tax-exempt yield, be careful. Look closely at the issues of any individual bond you buy, and invest through municipal bond funds with broadly diversified portfolios.

Why accounting matters

When pensions calculate their funding status, they account for two things: assets and liabilities. Assets are fairly straightforward to calculate — accountants sum up the value of the fund’s investments during the relevant time period.

Liabilities, however, are much trickier. A pension manager starts by calculating the benefits that employees are slated to receive at retirement, based on salary levels and years worked. Because those benefits don’t have to be paid for many years, just adding them up does not paint an accurate picture of the pension’s liabilities.

Imagine I’m a pension manager and my employee, John Doe, has already worked enough years to qualify for $20,000 in annual pension benefits. But the plan doesn’t have to start paying him these benefits until he retires in 2027, 15 years from now.

So, what’s the right way to calculate my 2027 obligations to John in terms of today’s money? The answer involves what’s called a present value. This value represents how much the plan needs to invest right now in order to pay John’s benefits in 2027. Because the plan can expect to make money on its investment between now and 2027, this present value will be less than the $20,000 it owes John.

In particular, the present value for the plan’s liabilities depends heavily on what’s called the discount rate. Roughly speaking, the discount rate is the return you expect to earn on the money you invest. The higher the discount rate, the lower the liabilities.

Here’s an example. If the plan earns an 8 percent return every year, it can invest $6,300 right now and be able to pay John his $20,000 in benefits in 2027. So, with an 8 percent discount rate, the present value of the plan’s 2027 liabilities to John is $6,300. But if it earns a 5 percent return, it must invest $9,620 now to fulfill its contractual obligations to John in 2027. In other words, changing the discount rate from 8 percent to 5 percent would increase the present value of the plan’s liabilities by about 50 percent.

Because discount rates are so fundamental to this calculation, it is critical to examine how pension funds select them. The remaining corporate pension plans are legally required to use the yield of certain high-quality corporate bonds as their discount rate — roughly 4 to 5 percent at this time.

By contrast, public pension plans are given much more leeway when it comes to choosing their discount rate. Under government accounting standards, pension managers can arbitrarily choose their “expected rate of return” as their discount rate. Instead of the 4 to 5 percent rate imposed on corporate pensions, most municipalities choose a rate near 8 percent.

And that rate seems unrealistic based on recent investment returns. Over the past 10 years, the Standard & Poor’s 500-stock index has achieved only a 1.9 percent annualized return. Although bonds have generally performed better than stocks over the decade, even high-quality corporate bonds have still achieved only a 6.5 percent annual return during this period. Thus, this 8 percent discount rate seems overly optimistic, though no one can predict investment returns with certainty. If an 8 percent discount rate is indeed too high, we are letting public pension plans significantly understate their liabilities.

Professors Robert Novy-Marx, then at the University of Chicago, and Joshua Rauh of Northwestern University examined just how much this matters. In 2010, they found that the liabilities of state pension plans would be more than 70 percent higher if they were required to use discount rates based on U.S. Treasurys — stricter than the corporate standard. Based on these assumptions, the total liabilities for state pension plans are understated by about $2 trillion.

Nevertheless, despite these serious accounting problems, the municipal bond market did very well in 2011. Municipal bond investors achieved a total return of 10.7 percent, including price appreciation and interest.

So why did municipal bonds outperform in 2011, despite their many problems? Municipal bond issuers still have the ability to raise taxes to finance increased contributions to local pension plans, so investors are not seriously concerned about a default — at least not yet. Furthermore, some municipal pension plans are in better fiscal shape than others — for instance, Washington state’s $58 billion in pension fund liabilities was 99 percent funded as of 2009, according to the Pew Center.

However, we believe that the weaker states and cities will find it increasingly difficult to fund their pension liabilities. Therefore, municipal bond buyers will need to choose their investments carefully, looking closely at the legal backing of the bonds and the unfunded pension obligations of the relevant governmental unit. To get this analysis right, you may have to ask for help from a financial adviser. Or if you prefer, you could invest through a municipal bond fund with a highly diversified portfolio. But don’t choose an aggressive or high-yield municipal bond fund if you want safety; these funds hold bonds that are riskier than average.

Prospects for reform

Fortunately, this analysis should get easier if revised accounting standards for public pension plans are adopted. The Governmental Accounting Standards Board, which writes accounting rules for issuers of municipal bonds, recently proposed to split “liabilities” into two parts:

1. Liabilities funded by current assets. These are the retirement benefits that the plan can pay out — based on its present assets and its 8 percent “expected return.” GASB will allow states and local governments to continue discounting these liabilities at their “expected rate of return,” as these would be paid out of long-term investments that GASB believes could potentially earn these high returns.

2. The shortfall. These are the benefits that won’t be paid for by the public pension fund’s existing assets — the “unfunded” liabilities. According to the GASB proposal, municipalities will have to choose a discount rate for these liabilities based on what they actually have to pay to borrow — that is, the yield of the municipality’s high-quality bonds. This rate would be much lower than the 8 percent rate currently in use.

This accounting proposal would certainly be a step in the right direction. If the rule were to take effect, analysts would have a better idea of how badly certain pension plans are underfunded. This transparency would help foster a dialogue about reforming pension plans, as it will become clear that the status quo is not a viable option.

But it is unclear how soon this proposal would be adopted and, if it is, how long it will take for local governments to respond to more accurate accounting by getting their fiscal house in order. So in the short run, if you want the tax-exempt yields of municipal bonds, follow these two guidelines: Stay with the general obligation bonds backed by the taxing power of large government units, and invest through municipal bond funds with diversified portfolios of high-quality bonds.

Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. On Twitter: @Pozen. Hamacher is president of Nicsa, @NicsaPres. Together they wrote “The Fund Industry: How Your Money Is Managed.”

Comments our editors find particularly useful or relevant are displayed in Top Comments, as are comments by users with these badges: . Replies to those posts appear here, as well as posts by staff writers.

To pause and restart automatic updates, click "Live" or "Paused". If paused, you'll be notified of the number of additional comments that have come in.

Comments our editors find particularly useful or relevant are displayed in Top Comments, as are comments by users with these badges: . Replies to those posts appear here, as well as posts by staff writers.